An Endless Game of Hide and Seek

Market surveillance needs permeate financial services firms from pre-trade to settlement, from trading via instant messenger services to exchanges and ECNs like never before in history. Every message, every trade, every conversation, every Tweet must be recorded, taped and downloaded into a database for on-the-spot or future scrutiny. Surveillance is necessary in order to provide full visibility to trading activity, whether via trade order flow, e-mails, Twitter, social media sites like Facebook or phone conversations. It’s invasive, there’s nowhere to hide.

U.S. hedge-fund managers are going so far as hiring security firms to comb their offices and homes for listening devices, according to new reports, reacting to the government’s insider-trading investigations. U.S. prosecutors used cell phone conversations as part of the evidence in the Galleon insider trading case. In the same vein, the UK's FSA has recently extended the recording of cell phones to hedge funds, and expanded taping rules for brokers to include all voice and electronic communications. If authorities are searching people’s homes for evidence against them, this illustrates the lengths to which they will now go to catch insider trading. And compliance officers need to be on top of this in every way they can.

"Intentional and unintentional disruption and behavior rocks investor confidence and every crisis and regulatory change increases the demand for better supervisory and monitoring techniques," said Mizen in the report.

Intentional behavior such as spoofing and ramping the market on the close, or insider trading need to be spotted and acted upon in a hurry. Brokers, trading venues and regulators need to know who is trading, what does it mean and is it correlated to something somewhere else?

In theory in an electronic environment it seems more likely that market abusers would be caught since so much data is captured. This, of course, depends upon the data. As monitoring and detection become more sophisticated the abuse bar is raised, but it will forever be a game of cat and mouse. Insider trading, for example, may manifest itself only in the painstaking reconstitution of conversations across multiple media, said Mizen.

The number of different places that trading activity can take place is constantly increasing. What used to be done exclusively in a trading firm's office at the trader's desk can now happen via cell phone - maybe by using a trading application or simply by phoning it into someone in the office. Or a trader can begin to work a deal at the office, go for lunch and finish it via instant messaging with his broker.

Compliance officers need to have full visibility in order to spot and prevent abusive trading activity - and that vision has to encompass trade order flow, e-mail conversations, Twitter, social media sites like Facebook, and phone conversations - even at home. In Europe, the Market Abuse Directive extends the notion of market manipulation to cover over-the-counter (OTC) instruments that can influence the price of listed instruments.

But even as the compliance side ramps up surveillance, there is a move toward making the front office more responsible. Trading desks will increasingly ensure that they don't do anything stupid, either with fat fingers or with an algorithm that goes rogue. Surveillance procedures can actually help them to trade more effectively, knowing that mistakes will be caught.

Changes in regulation paint a scary picture for brokers, with Dodd Frank, the flash crash, the market access rule and large trader reporting all crashing onto their plates. There is a need for constant monitoring and for the data to be analysed, scrutinized and stored and retrieved on demand.

The market access rule in the US will really change the game plan; brokers will have to apply pre-trade risk controls to every client using their market access, checking order size and credit limits in real-time. Although this is a relatively simple concept at a high level, the devil is in the very high speed details, and it can create a 'speed bump' to the order process, which could damage business. This creates another challenge; the broker needs control, a view across asset classes and client positions, with as little time lag as possible.

With increasing ownership of risk across the enterprise, the growth of social media and other off-trading-floor activity, the scope of surveillance becomes broader by the day. For further insight please go to Mizen's report - Dynamic Surveillance: Detection, Prevention and Deterrence - on the Progress website.

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